Q&A: What to Make of China's Troubles

Jason Stipp: I'm Jason Stipp for Morningstar. As China continues to dominate the headlines day by day, our director of economic analysis, Bob Johnson, has also given his view on the situation. Most recently, in his weekly column, he got a lot of reader response, and he wants to address some of those questions that were raised.

Bob, thanks for joining me.

Bob Johnson: It's great to be here today.

Stipp: You've been closely following what's happening in China. You've also gotten a lot of questions from readers. I want to play the reader's advocate and ask you some of those questions so that you can respond to a number of them.

First of all, you had some questions asking why you are even spending so much time following China. Yes, it's dominating headlines, but it could just be short-term noise. What's the benefit and how should long-term investors think about shorter-term events like what is happening in China right now?

Johnson: It's always a hard thing to talk about the short run because we always say to be focused on the long run. And that's really what's important--what the long-term trends are. But sometimes those long-term trends become visible through short-term trends that continue to develop. Often, people are confused in their investing; they see the headlines, and they want to react to them. Sometimes, we want to stop that and say, "Wait, there's another way of looking at this data," or we say, "The data this week does change the way we're thinking about it." So, it does add a little bit of incremental value.

It isn't possible to pinpoint any given week what necessarily moves the market. It's highly complex. We all know that. And a lot of times, we're more certain than others about what moves things, but when the Fed announces something at one o'clock and the market is down 200 points by 1:15, you know that it's probably at least temporarily reacting to that. And certainly, as many people pointed out this week, what may be happening is that it's kind of a triggering event, and now people are realizing what's happening in the rest of the world as well.

It's kind of the Wile E. Coyote and Road Runner syndrome, where he runs out over that cliff, seems to be in suspended animation, looks down, and then begins falling once he realizes what's going on.

Stipp: So, the important thing is to look at the longer-term trends, and then you can analyze incoming data in the context of those longer trends. Sometimes it changes your opinion and raises a yellow flag; sometimes you realize that the short term maybe is an anomaly--it's a blip and you need more evidence before you change your mind.

Johnson: Exactly.

Stipp: Another comment you got was that you are giving China way too much credit. The real problem with the economy are things that are happening right here in the U.S., and China is just a scapegoat. How do you respond to that?

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Johnson: The readers are a little bit right on that. The one thing that's very important to keep in mind is indeed, as many readers pointed out, we are much more important to China than vice versa. We import four times as much stuff from China than we ship to China--a 4/1 ratio. Then on top of it, their economy is two thirds the size of ours. So, it's an even bigger differential. So, clearly, readers had that right--we're probably more important to them.

On the other hand, it's hard to ignore the world's now second-largest economy. Even when I started in this job six or seven years ago, China was not as big of a player. But when you grow at 12% growth rates, you double pretty darn quickly--and theydo make a difference.

Stipp: Also, when you think about the impact of changes in China and natural resources and the countries that are also involved with natural resources, you can see why some of these knock-on effects are happening in the global markets.

Johnson: Absolutely. They are extremely important in some markets. In many commodity categories, they absorb 40% of the output, and so you just can't ignore them. If you're looking at U.S. exports of consumer goods, it's kind of irrelevant; we don't ship much to them. So, it really depends on who you are, where you are, and what supply chain you are involved in.

Stipp: So, let's agree that China is worth keeping an eye on and worth monitoring. But then the other question that comes up is that, sure, the economic data we got out of China recently didn't look great, but it hasn't looked great for a while. So, why now are a few bad pieces of data out of China causing such a big problem for world markets?

Johnson: That's one point that I didn't make well enough in last week's column: I think that lately it's been more a crisis of confidence in China's management than the actual economic data. We saw them flip a couple of times regarding whether they wanted the currency to be stronger or weaker. Do they want to put circuit breakers in or do they want to take the circuit breakers off? Do they want to support the market or do they not want to support the market?

They've been pretty rock-solid in what they're doing, and they've been highly successful. Everybody touted their model--even over the U.S. model--saying, "Some of this command-and-control stuff kind of works and makes for a more stable economy and a better situation." And [last] week when they came up all lemons on some of their decisions, everybody was quick to lose confidence--probably more than they should have. But that's what I think it was really all about. They seem to have lost the magic wand, if you will. It wasn't that any piece of data was particularly bad.

Stipp: Something else that I think readers are concerned about and think might be causing some of the pain is that the growth in China is entirely a mirage. They think that we can't trust the data. There are empty shopping malls; they have overbuilt. That's why now we're seeing more attention on this, and the market is realizing it. This is why there is so much pain there. How do you respond to this argument that China is falling into shambles?

Johnson: I absolutely don't believe it. I think that if you look over the long term, their economy has done exceptionally well--double-digit growth dating at least back to 2000. This is not a flash in the pan or China saying, "We've got some new government program that's made things better," or "We've temporarily devalued the currency, and we've done a little better for a couple of years." There are parts of the world that have been through two or three up-and-down cycles over the time that they have had a straight, continuous growth pattern. So, you really can't fault what's going on there. And if you've ever been there and seen the buildings that are going up there and the port facilities and the manufacturing, or if you are somebody here in the U.S. that competes against them, they are real.

Stipp: But what about some of the empty shopping malls? We've seen the stories that show that these exist. There has been some overbuilding, right?

Johnson: Sure. In a $10 trillion economy, you can always find something there. Here in the United States even, I recall the "bridge to nowhere" we had up in Milwaukee. It's always possible to have some misallocation or something that looks a little bit silly--especially in an economy that large, that diverse, and under a fair amount of local control. Now, that's not to say there aren't a few projects that have gotten out of control or that you couldn't find something that's overbuilt here or there; there's no doubt that there is a little excess capacity in the Chinese economy. But it's not some kind of mirage; it's not as if there's no demand for it, or that they have built all of these totally stupid things all over the place that don't make any sense. That's not reality. They've done exceptionally well. It's very hard for employers to hire and retain people in China, which is another fundamental sign that there is strong underlying demand.

Very smart companies like Apple (AAPL) do much of their production out of China. They could do things wherever they want--wherever it makes the most sense from a broad range of considerations, including the strength of the infrastructure or the cost. Considering all of those things, that's where they've decided to put their efforts. So, that's another thing that I'd consider. Certainly, yes, some of the data here and there is a little bit more liberally interpreted than ours is; it seems to flow unnaturally in straight lines once in a while. But if you look at the longer-term trends, they seem to have found the handle for how to make an emerging market grow a little bit faster than it might otherwise.

Stipp: What do you think a more realistic longer-term growth rate is for China, then?

Johnson: I think that they could very easily do 3% to 5% for an extended period of time. Sure, that's not the 10% to 12% that we are all used to; but if you're not exporting a lot, if you're not building a lot of new infrastructure, and you've got no population growth, it's kind of hard to grow fast.

Stipp: Let's talk about some of the other concerns over China. They are, obviously, shifting from more of an investment-led economy to a more consumer-led economy. There are concerns that that's not going to be managed well and they're going to have a hard landing. So, some of the market volatility may have to do with people realizing that hard landing is going to happen. What's your take on the possibility that this is the outcome?

Johnson: It's always a possibility. And a lot of the emerging-markets countries that are now developed--or at least higher up the food chain in the world--have gone through issues like this. Even in, say, Japan, where you went through a period where it was all export driven and then it was a little bit more import and then more consumer. And as they made the transitions, there were big stops in the GDP growth rate. There was volatility; it wasn't as simple as them saying, "We're slowly going to be more consumer-oriented because our neighbors are getting too mad at us." It was a very uncomfortable situation. You could pick Korea, Taiwan--the world is littered with it. It's much easier for the government to borrow and spend money on big infrastructure projects and to sell less-expensive products overseas than it is to generate domestic demand. Those are harder things to keep going in the right direction.

Stipp: Lastly, I think some folks are wondering whether the sell-off in the United States is more related to U.S. fundamentals. Some of the economic data hasn't looked great recently. Is the sell-off that we're seeing in the U.S. not really about China but about the U.S.?

Johnson: That was one of the more intriguing questions on the column, and I really did have to go back and look to formulate an answer to that. We look at a lot of data, and we're very careful. We usually look at year-over-year average data and try to have an inflation-adjusted set of data to boot. But if you look at a lot of the sequential data and ask how did November look versus October or December versus November, you kind of get a different answer. Auto sales for three months in a row have been about 18 million units on a seasonally adjusted annual-rate basis--now it looks more like 17 million.

Retail sales: We've all heard the stories about the poor Christmas season and so forth. So, there are some concerns out there. But again, I would contend that most of that has to do with weather. Certainly, apparel has had a crummy year because of the weather. And believe it or not, in the GDP calculations, lower utility usage can have a huge impact. It could take at least a few tenths of a percent off, if not more, in any one given quarter.

So, there are a lot of special factors in there that always affect the sequential data a little bit more because you are taking just one month and then you are multiplying it by 12 or you're taking a quarter and multiplying by four. So, it really accentuates the problems.

But then if you look at some of the longer-term data--or something like employment that's hard to artificially jump around--the growth rates have been rock-solid at right around 2% going back to 2010. I've joked about the ocean-liner economy--not barring some readers who say that ship I'm seeing is the Titanic--but we have certainly seen a situation where we've had some pretty incredible stability on an overall basis. I think that's what's confusing the issue.

Stipp: So, again, going back to your original point, it's important to keep the longer term in mind as you are interpreting data that's coming in on a month-to-month or even a week-to-week basis. Lastly, if the U.S. is stable, should the U.S. be able to help the rest of the world, then, if we're seeing pressure in the rest the world?

Johnson: Usually, you'd say yes. And certainly when the U.S. does well or even similar to how we're doing now, it draws in a lot more imports. But the news there has not been good for people who are importing things. There are a lot of trends that are happening in the U.S. that are really driving down imports--or at least slowing the rate of imports--and the effects are really pretty dramatic just in the last quarter.

Again, I should caution against using just one month's or quarter's worth of data, but the reason the trade deficit narrowed was because both imports and exports fell but the imports happened to fall more. So, it's been a problem.

The issue is that the demographics of the United States change. We use more healthcare or people want to travel more; people want more experiences and fewer goods; some of the weather issues in the short run. We just don't want as many goods. We're spending on things that are more made in the United States.

Even in the auto sector, the real growth has been in pickup trucks and vans and crossover vehicles, which are predominantly--because of terrorists--made in the U.S. So, that's even driven down some of the demand for autos from overseas--something you can always count on for us to draw in a ton from.

People are eating more meals out, and you can't export that type of service. So, clearly, where one would have expected the U.S. to be the savior, it has not been. And even some of China's problems right now probably relate a little bit to the fact that Apple is having to trim back a little bit on what they were doing in China manufacturing-wise. So, there are a lot of linkages here, and unfortunately the U.S. hasn't been as helpful as they might have been in other years.

Stipp: Bob, thanks for answering readers' questions and giving us your perspective on how you look at and interpret the data as it's coming in.

Johnson: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.